In today’s option trading blog I want to try and save you some money. Have you ever been long an in-the-money (ITM) option and cursed at the Market Makers because the options were bid under parity? I have and there is a way to by-pass them altogether. This article could save you hundreds, maybe thousands of dollars.

Let’s look at an example. You are long 10 of the $50 calls and the stock is $58 x $58.10. The options are $8 in the money but the market on them is $7.80 x $8.20. You want to get out at a decent price so you try to sell them at $8. The order sits and it never gets filled. Now you get angry because you know that you are being taken advantage of. The Market Makers are in the business to make money. They figure you don’t know any better and eventually you’ll hit their bid. Here’s how to get out and keep your money.

The first thing you need to do is to find out how your brokerage firm handles this transaction. You are long calls and you can exercise your right to buy the stock at $50 – theoretically you’re long stock. If you sell the stock and exercise your calls you will be “flat”. The transaction is short exempt by rule and reg. and you have what’s called – same day substitution. This means you don’t have to put up the stock margin if it is done the same day. The brokerage firm will require advance notice of your intent to exercise. Once they have it they will create an offset that makes your account long 1000 shares.

Here’s how you handle the trade. Lets say that the stock is offered at $58.10. You place an order to sell the stock at $58.05 and you get filled. Now you exercise the call. The net affect is you bought shares at $50 and sold them at $58.05. Your net price is $8.05 which is $.25 better than the $7.80 the Market Makers were willing to give you. That’s $250 in your pocket. The Market Maker was hoping to do the reverse. First he would buy the calls for $7.80 and then he would hit the $58 bid on the stock. The end result is a quick $200 risk free profit.

If you have the margin available in your account and you are selling the stock on an uptick, you can just do the transaction without notifying the brokerage firm in advance. You do need to put in an exercise notice either verbally or through the trading application so that both sides of the trade clear and the margin is released.

This neat little trick works in reverse for put positions. It will save you a lot of money and frustration. It will also let you “work” an order using the stock which is much more liquid.

Have you ever had to deal with this rip-off? If so, share your experience with others.

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